ATO Interpretative Decision

ATO ID 2004/525 (Withdrawn)

Income Tax

• This ATO ID is withdrawn as the interpretative issue is covered in Taxation Ruling TR 2004/4.
  This document has changed over time. View its history.

Issue

Is the taxpayer entitled to a deduction, under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), for interest incurred during the income year that relates to the purchase of an income producing asset that was sold in a previous income year?

Answer

Yes. The taxpayer is entitled to a deduction, under section 8-1 of the ITAA 1997, for interest incurred during the income year that relates to the purchase of an income producing asset that was sold in a previous income year.

Facts

The taxpayer borrowed funds from a bank on a line of credit facility and used the funds to acquire a commercial property. The commercial property returned rental income to the taxpayer.

After several years the taxpayer sold the property for substantially less than the cost of acquiring it. The taxpayer used the proceeds of the sale to pay off as much of the outstanding debt as possible, however almost half of the original debt remained outstanding.

The taxpayer attempted to meet repayments on the remaining loan out of other income, but was unable to and eventually refinanced the debt. The taxpayer has incurred interest expense on this subsequent borrowing in the current income year.

Reasons for Decision

A deduction is allowed under section 8-1 of the ITAA 1997 to the extent that the loss or outgoing is incurred in gaining or producing assessable income, or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, a deduction is not allowed under the section where the loss or outgoing is of a capital, private or domestic nature, or is incurred in producing exempt income, or where another provision prevents a deduction.

In Placer Pacific Management Pty Limited v. FCT (1995) 31 ATR 253; 95 ATC 4459 the full Federal Court held that an expense will not cease to be deductible simply because the assessable income was earned in a year prior to the incurring of the expense. Therefore, the interest expense will be deductible under section 8-1 of the ITAA 1997 if there is a sufficient nexus or connection between the incurring of the interest expense and the assessable income that was produced by the asset that was originally purchased with the borrowed funds.

At the time the borrowing was taken out there was clearly a sufficient nexus or connection between the assessable income and the interest incurred on the borrowing. This is because the borrowed funds were used to purchase an asset that produced assessable income, namely rent. However, what needs to be considered is whether the relevant nexus was subsequently broken, either when the asset was sold or when the loan was refinanced.

The issue of the deductibility of interest after the cessation of income earning activities has recently been examined by the courts in FCT v. Brown (1999) 43 ATR 1; 99 ATC 4600 (Brown) and Commissioner of Taxation v. Jones (2002) 117 FCR 95; (2002) 49 ATR 188; 2002 ATC 4135 (Jones). In both these cases the taxpayers incurred interest on outstanding loans that were unable to be repaid after the income earning activities of the taxpayers had ceased. In both cases the courts held that the interest expense was deductible despite the interest having been incurred in a year after the year in which the relevant assessable income was earned, and despite the fact that the income earning activities of the taxpayers had ceased prior to the incurring of the interest expense.

In Brown the court commented by way of obiter that the outcome may have been different if the loan had been a 'rollover' business loan facility. The court said at (1999) 43 ATR 10; 99 ATC 4608 that:

In such a case the cessation of business or sale of the income-producing asset acquired with the borrowed funds might properly be regarded as breaking the nexus...

In the present case the loan facility is a line of credit and fits the description of the 'roll over' business loan facility mentioned in Brown. However, the full Federal Court in Jones clarified the statement in Brown regarding 'roll over' loans by stating:

In our view the obiter dictum in Brown deals with the case of a true election - where the borrower has the resources to pay out the loan but decides not to and rolls the loan over instead.

Following the decision in Jones a taxpayer's capacity to repay the outstanding debt needs to be taken into consideration when determining whether or not the relevant nexus has been broken.

In the present case the taxpayer did not have the capacity to repay the outstanding debt remaining on the line of credit and hence there was no true election to roll the loan over. The loan was not kept on foot for any other purpose but simply because the taxpayer did not have the funds to repay it. Therefore, in accordance with the decisions in Brown and Jones the relevant nexus between the interest expense and the assessable income earned previously from the asset is not broken.

The refinancing of the loan will also not break the relevant nexus between the interest expense and the assessable income gained from the asset. The court in Jones stated:

It is well-established that when an original borrowing is refinanced, the new financing takes on the same character as the original borrowing. The character of the loan is not changed. See Commissioner of Taxation v Roberts (1992) 37 FCR 246 at 257; 23 ATR 494 at 504; 92 ATC 4380 at 4388 and Federal Commissioner of Taxation v Midland Railway Co (WA) Ltd (1951) 85 CLR 306 at 313.

Therefore, the nexus between the incurring of the interest expense and the earning of assessable income from the asset has not been broken by either the sale of the asset or the subsequent refinancing of the loan. As the nexus between the incurring of the interest expense and the earning of assessable income from the asset has not been broken a deduction under section 8-1 of the ITAA 1997 is allowable for the interest expense incurred.

Year of income:  Year ended 30 June 2001

Legislative References:
Income Tax Assessment Act 1997
   section 8-1

Case References:
Placer Pacific Management Pty Ltd v. Federal Commissioner of Taxation
   31 ATR 253
   95 ATC 4459

Related Public Rulings (including Determinations)
Taxation Ruling TR 2004/4

Keywords
Interest expenses

Business Line:  Business and Personal Taxes Centre of Expertise

Date of publication:  25 June 2004

ISSN: 1445-2782